How to Tax-Manage Your Client’s Portfolio

Its tax time. Do you know where your clients assets are allocated?

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It’s tax time. Do you know where your clients’ assets are allocated?

As the 2012 tax filing deadline draws near, financial advisors are studying what the Taxpayer Relief Act means for their clients’ portfolios—and how to better tax-manage their assets at every point along the wealth spectrum.

Even though President Barack Obama signed the act into law on Jan. 1, uncertainty remains about where the tax code is headed. For example, Dan McElwee, executive vice president of registered investment advisor Ventura Wealth Management in Ewing, N.J., says that one of his biggest challenges is that the future tax picture out of Washington remains fuzzy.

McElwee, a certified financial planner and FPA member, recommends that advisors construct portfolios that are diversified from a tax perspective, using as many tax advantages as possible, because what the tax landscape will look like 10 years from now is unknown.

He suggested that a core portion of a client’s portfolio should go into low-turnover index funds such as the SPDR S&P 500 (SPY), and also stressed that the risk of a sudden spike in interest rates now adversely affects municipal bonds’ reputation as a safe haven of tax-free income.

“Giving retirees different buckets to draw from is incredibly important,” he said in an interview with AdvisorOne. “Having a Roth IRA so retirees can make tax-free drawdowns is important, but having a traditional IRA is good, too, depending on what happens to the tax code. Unfortunately, there aren’t many places to go.”

Tailoring Tax Advantages for the Wealthy

For high-net-worth individuals, separate accounts are a good option for tax management because they can be tailored specifically to HNW portfolios, writes David Stein, chief investment officer for the asset management firm Parametric, in a white paper, “Tax-Efficient Equity Investment: A Primer From Parametric.”

Parametric’s tax-managed separate account product, called Tax Managed Core, has an account minimum of $250,000 and is designed for the HNW investor to increase returns with low volatility. Like McElwee, Stein foresees that the fiscal challenges facing the U.S. “could translate into further tax hikes down the road.”

In the primer, Parametric concludes that investment managers have six basic techniques they can use to build a tax-management strategy and increase a portfolio’s tax efficiency:

Defer the realization of gains. ”An increase in the value of the investment increases the future tax liability, but the payment of that liability can, in some instances, be deferred indefinitely, allowing that money to compound over time,” Parametric says. “For some investors, the cost basis of assets in an estate is reset at the taxpayer’s death. As such, the ‘loan’ never needs to be repaid. This is the bread and butter of tax management.”

Manage the holding period. Capital gains from the sale of a security are taxed as ordinary income, Parametric notes. But holding the investment longer than 12 months qualifies it for a lower tax rate.

Harvest losses. When the price of a security falls below its purchase price, the result is a realized capital loss that can offset capital gains. “While many investors only harvest losses in December, this activity is far more valuable if it is done throughout the year within an overall portfolio management process,” Parametric advises.

Consider the yield. Tilting away from dividend-paying stocks toward capital appreciation can also increase tax deferral and reduce the tax bill. “But be wary of the allure of low yields,” Parametric warns. “Low payout ratios are no assurance of faster earnings growth.”

Pay attention to tax lots. In many cases, tax-savvy managers use “highest in, first out,” or HIFO, tax-lot accounting when selling securities to reduce a portfolio’s tax burden. But in other cases, HIFO might not be the best solution. “For example, an investor with a tax-loss carry-forward may find it beneficial to accelerate gains,” Parametric says. “Investors who need to generate cash flow from their investments or have charitable giving plans will benefit from a manager who pays attention to identifying the best tax lots for each event.”

Avoid wash sales. Repurchasing securities within 30 days of sale is a bad idea from a tax-management perspective, especially if an investor uses multiple managers, Parametric says. “For example, the tax loss generated by manager A will be voided if manager B buys the same security within 30 days.”

Morningstar’s Benz: Model Portfolio for Retirees

Meanwhile, within the mass-affluent category, Morningstar’s director of personal finance, Christine Benz, wrote last month that a low-risk way for retirees to boost their take-home returns is to manage their portfolios for optimal tax efficiency.

“Most retirees are in drawdown mode, and some strategies for tapping your accounts for income incur fewer tax-related costs than others,” Benz warned in a note, “A Conservative Tax-Efficient Portfolio for Retirees.” “Moreover, there’s only so much money you can shelter in tax-protected vehicles, so many people come into retirement with substantial shares of their portfolios in taxable accounts.”

The higher the level of wealth, the more this is true, Benz wrote, adding that bonds and cash investments, and the income from them, are taxed at a higher rate than for withdrawals from equity accounts. Sequenced withdrawals from retirement accounts are key to tax management, she said, and tax-efficient investments should be concentrated in taxable accounts while less tax-friendly investments should go into IRAs and company 401(k)s.

Benz, who doesn’t share McElwee’s concern about muni bond risk, then gave an example of what a conservative retiree’s taxable portfolio might look like:

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